“I’m not saying there aren’t legitimate expert networking firms, but they are a little bit like putting a group of teenagers together in one room with a lot of booze — something is going to happen,” said Columbia Law School Professor John Coffee.

“The expert network says there shall be no exchange of material non-public information, but why is the hedge fund paying $30,000 or $40,000 to meet those people?”

The SEC on Tuesday alleged that $276 million in illegal profits or avoided losses were made by hedge funds trading ahead of negative news in July 2008 on a clinical trial involving an Alzheimer’s drug.

In the case, the SEC alleges that hedge fund portfolio manager Mathew Martoma traded on confidential information about a drug trial provided by Dr. Sidney Gilman, chairman of a safety-monitoring committee overseeing the clinical trial and a paid consultant to an expert networking firm. Read about SEC alleging largest ever insider-trading scheme

“They are a little bit like putting a group of teenagers together in one room with a lot of booze — something is going to happen.”
John Coffee, Columbia Law School

According to the SEC complaint, Gilman met Martoma through paid consultations arranged by the networking firm and Gilman received more than $1,000 an hour for his advice. Martoma, portfolio manager at CR Intrinsic Investors, is owned by S.A.C. Capital, the hedge fund founded by Steven A. Cohen.

The SEC said the expert networking firm provided training about federal securities laws to Gilman, reminding him not to share non-public information with clients.

Nevertheless, the insider-trading alleged in the charges stem from connections made through the expert networking group, a trend in many insider trading cases brought by the SEC.

In the spring of 2009, the SEC launched an expert networks investigation, seeking to identify more insider trading related to these intermediary firms.

“The SEC has brought a whole series of cases that really began out of the Galleon investigation and branched into Primary Global,” Gorman said.

Since then, in February, 2011, the SEC charged four technology company employees who the agency said “moonlighted” as consultants to Primary Global Research.

So far, the agency has charged 25 defendants as part of its expert-network firm investigation, with alleged illicit profits of about $120 million. (If Tuesday’s action were to be included, because an expert networking firm was involved but not charged, that number would be increased to 28 defendants and $400 million of alleged illicit profits).

Overall SEC insider-trading cases are up, with the agency filing 58 actions in 2012 and 57 last year, according to a Nov. 14 commission report. The agency has filed 168 insider trading actions since 2009, the most ever in a three-year period in the SEC’s history.

Stephen Crimmins, a former SEC enforcement attorney, argues that hedge funds need to generally do a better job of setting up limits on the types of individuals that portfolio managers can speak with. He suggested that fund managers require that compliance officers participate with traders in conversations with experts.

“If you are researching a particular pharmaceutical company, you don’t want to speak to someone at the company or working on the subject but you may want to speak to other scientists that are generally familiar with that research area,” Crimmins said.

Insider-trading and expert networkers

And beyond Tuesday’s charges, there are numerous other cases of insider trading involving people consulting for or managing expert networking firms.

In January, SEC Enforcement Director Robert Khuzami said that “an organized network of analysts and fund traders” was involved in charges brought against investment analyst Sandeep Goyal and two big hedge funds. Read about the SEC charges

In February, the SEC charged John Kinnucan and his Portland, Ore.-based expert consulting firm Broadband Research Corp. with insider trading.

Following that, in June, the SEC charged Tai Nguyen, owner of California-based equity research firm Insight Research, with insider trading in charges stemming from the commission’s expert networking firm investigation.

According to the SEC, Nguyen allegedly traded on confidential information he obtained in advance of earnings announcements by Abaxis. He also passed the same information to Insight’s hedge fund clients, the SEC said, “who used the inside information to make millions of dollars in profits.” Read about the SEC's complaint in the Insight Research case

Gorman, a former SEC enforcement attorney, said the trend of some expert networking firms crossing the line has scared hedge funds and other investors from seeking out information from these firms.

“What is happening now is people are reluctant to deal with these organizations because of the potential for liability,” Gorman said. “The expert network group industry itself is taking a hard look at how they can conduct their business because of significant questions being raised.”

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